On Tile Shop's Inventory

As an analyst covering retail sector, the first things we are taught is that high inventory level is a red flag. So, when we see a company like Lumber Liquidators (NYSE:LL) with 5 months of inventory we become a bit worried. We also are surprised that industrial distributor Fastenal (NASDAQ:FAST) whose shares have risen 377 times over the last two and a half decade has 6 months of inventories [2-3x higher than its peers W.W. Grainger (GWW) or Applied Industrial Technologies (AIT)]. And we are fast to conclude that there is certainly something wrong with Tile Shop (NASDAQ:TTS) with its current inventory levels and its stock should trade at lower levels.

But before jumping to conclusion, why not we take a step back and revisit the basics to understand what the problems with high inventory levels are. The problems are two-fold. The first one is increased possibility of write downs and the second is poor return on capital employed (ROCE) as money is tied up in inventory. If there are two similar companies with only difference is that one uses a higher amount of inventory than other to generate same amount of sales, the company with higher inventory level would have a poor ROCE. But in real life the companies are rarely similar and there are various different variables at work. If a retailer tries to remove intermediaries and start direct sourcing it will have to set up its own supply chain infrastructure and it will end up with higher level of inventory. At the same time it will save on the cut it has to otherwise pay those intermediaries and will see improved margins. If done correctly, direct sourcing will lead to improved returns despite of higher inventory levels. With that in mind let us go back to our discussion on Tile Shop.

Tile Shop's inventory is high because it is not only acting as a retailer but it is also involved in the sourcing of products directly from the manufacturers removing all intermediaries. This approach does involve a risk in the form of potential supply disruption if the company is not able to manage it sourcing properly and the company has to devote significant resources in the form of inventory in its distribution centers to mitigate it. However, reward of this approach significant outweighs the risk. The product we are talking about in this case -Stone Tiles- doesn't wear of or become out of fashion in a short time span. The actual price a manufacturer located in Asia is getting in this case is hardly 10% of the retail price this product is being sold at in the U.S. (Check Alibaba, Tile Shop website). The rest goes to intermediaries and for transportation. Rewards (increased profitability) of going deeper into this type of supply chain far outweigh risks.

It is not Tile Shop alone which has adopted this model. Lumber Liquidators has the same model. As Lumber Liquidators continued to penetrate its supply chain, remove intermediaries and go for direct sourcing its inventory levels (DSI) have doubled. At the same time its Gross Margins have also expanded significantly.

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In addition to direct sourcing model, Tile Shop's rapid expansion has also lead to high level on inventory in the last quarter. The company has plans to open 10 new stores during December quarter and increase its store counts from 80 to 90. That is a 13% increase and a spike in working capital during these times is normal. Similar spike happened in the first quarter of 2012 when the company increased the number of stores from 53 to 60.

According to Gotham City Research whenever such spike occurs, it is a fraud and you should subtract the excess inventory growth from profits to arrive at actual earnings. No, I am not joking or making this up - he has actually done his calculation based on it to claim that the company overstates its earnings.

We estimate the inventory overstatement by calculating what the inventories would be if it had grown at a rate in-line with sales and COGS growth. We calculate the difference between the reported inventories and our estimate for actual inventories, and then add that difference to cost of sales.

If you want to believe his work, more power to you! However, in reality I don't think he understand the company's business.

Comparing Tile Shop with others

One of the problems in comparing inventory levels of Tile Shop with others is that it would be penalized for its low COGS and high inventory levels which are a good thing as both are a result of the company's sourcing initiatives which are helping the company improve its profitability. If we want to compare Tile Shop with its peers and find out if it makes business sense for Tiles Shop to block its capital in inventory, the better metrics would be how much sales and profitability it is able to generate per unit inventory. Below is the comparison:

We can see that while Tile Shop is able to generate similar amount of sales per unit of inventory held as Lumber Liquidators, it profitability is much higher. This is expected as Lumber Liquidators has four walls contribution margin between 10-14% and Tile Shop has it at 25-28%. Also, the profitability per unit of inventory held is highest for Tile Shop among all of the above companies implying that Tile Shop's capital blocked in inventory is actually paying off in terms of significantly higher profits. Thus, Tile Shop's strategy of direct sourcing makes a good business sense.

Valuations

Tile Shop's stock has corrected significantly post Gotham's erroneous report. The company is now trading at an EV/EBITDA of 13.6x and 10.6x FY13 and FY14 consensus estimates.

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I believe the company deserves to trade at a premium to Lumber Liquidators given the fact that it is still in the starting phases of its expansion and has much better profitability. Further it appears that the company has set Wall Street's expectation on the conservative side. The company has 86 stores but its four distribution centers which are functional can handle up to 200 stores. And this is just on the eastern side. The company's has significant white space in the west and is planning to start its expansion and open two distribution centers there. For FY13, the company guided to opening 17 stores but it is likely to open 20.

To sum up, Tile Shop's inventory levels are high because it not only acts as a retailer but is also involved into direct sourcing of its products by removing intermediate distributors. Although this practice increases its inventory levels, it makes business sense as it significantly increases its profitability. Post Gotham's report Wall Street is wrongly interpreting the company's margins and inventory levels. As sanity returns, I expect stock to trade north of $20 in the near term with a potential to give significant appreciation in the long term.

Disclosure: I am long TTS. The analyst who wrote this article is long Tile Shop. GS Analytics Pvt. Ltd. or any other employee/shareholder have no position in the company. We are recommending TTS as a long candidate to our clients.

Business relationship disclosure: GS Analytics is a financial research firm providing customized research services to U.S. hedge funds. This article was written by one of our Research Analyst. We did not receive compensation for this article (other than from Seeking Alpha), and we have no business relationship with any company whose stock is mentioned in this article.

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